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Stick With South Korea in 2014

Jan. 6 (Bloomberg) -- Consider what would happen if the
totalitarian regime in North Korea collapsed and that vastly
underdeveloped country of 25 million was absorbed by South
Korea, with its 50 million highly motivated and industrious
citizens.

Despite the huge initial costs, South Koreans yearn for
this opportunity; China’s leaders probably don’t. One reason
China supports North Korea is probably the desire to keep a
buffer between China and South Korea and to force the South to
maintain an expensive military establishment to counter the
belligerent North.

Furthermore, as shown by the merger of West and East
Germany after the Berlin Wall came down in 1989, it isn’t easy
to recombine two groups of people that have been separated by
distinct cultures for decades. Even today, 24 years later,
incomes are lower in eastern than western Germany.

Meanwhile, South Korea looks like the best of the
developing/semi-developed countries in terms of economic growth
and stability as well as investment opportunities. After the
global recession of 2007-2009, growth has been sluggish in the
U.S., the euro area, the U.K., Japan and other developed lands.
Meanwhile, the economies of China, South Korea and many other
developing countries revived and grew much more rapidly.

This convinced many equity investors that the real action
was in emerging markets, where equities rose much more than in
developed countries from March 2009 until mid-2011. Once again,
investors forgot that those economies are all driven by exports
that are bought by developed countries, principally the U.S. and
Europe. So if mature economies are growing slowly, rapid
expansions in developing countries are unsustainable.

I say once again because this belief that developing
economies could decouple from the developed ones also was
prevalent at the global economic peak in 2007. Many thought that
China would continue to advance rapidly, despite signs of a
flagging U.S. economy. I disagreed with this analysis.

Back then, I wrote that Wall Street hoped economies such as
China and India would lead global growth as U.S. housing and
consumers faltered. Those economies, particularly China’s, were
driven by exports, which account for about 40 percent of gross
domestic product. And because most exports, directly or
indirectly, are bought by U.S. consumers, volume would drop as
Americans retrenched.

China’s economy could shift to being domestically driven if
its middle class were big enough and inclined to spend freely.
But Chinese consumers save a third of their income to cover old
age, health and other costs no longer provided for by the
government. The stock market bubble there attests to huge
savings with few investment alternatives.

And although there are an estimated 110 million people in
China’s middle and upper classes, that represents only 8 percent
of the 1.4 billion population, and these elites control just 25
percent of GDP. In contrast, the U.S. middle and upper classes
make up about 80 percent of our 300 million people, with incomes
that equal 80 percent of GDP. I expected the U.S. recession to
spread globally, even to China. It did, of course.

The 2011 financial crisis in the euro area scared equity
markets globally, but equity investors still viewed emerging
markets favorably because of the rapid growth they expected to
continue. Also, a number of these countries had higher interest
rates than in the West and Japan. This appetite, which I call
zeal for yield, has been robust, and many investors went after
high returns anywhere they could find them, regardless of risk.

Also, many equity investors regarded all emerging markets
as largely similar. But the weakness in most emerging equity
markets that began in 2011 also was probably anticipating
slowing growth there while activity in developing countries was
expected to pick up. Since 2010, growth in developing nations
has fallen by three percentage points to an annual rate of 5
percent, according to the International Monetary Fund. From
January 2012 through October 2013, the Organization for Economic
Cooperation and Development’s indexes of leading economic
indicators showed an increase of 0.8 percent for the U.S. and
1.2 percent for the euro area, but a decline of 2.4 percent for
India and Indonesia, 2.6 percent for Russia and essentially no
change for Brazil and South Africa; China fell 0.5 percent.

Furthermore, in May and June, the U.S. Federal Reserve
started talking about tapering and then ending its $85 billion a
month of security purchases. Investors who had rushed into
emerging markets stampeded out, depressing equity markets. This
was especially true of Brazil, Turkey and Indonesia, which have
sizable current-account deficits and lack the cushion to offset
the money outflows. Big commodity exporters such as Brazil also
have been hurt by declining commodity prices.

In their effort to curb the hot money retreat, some
countries have raised interest rates, weakening their currencies
and spawning inflation. This risks further depressing growth. In
Brazil, for example, the central bank rate is 10 percent,
inflation is running at 5.8 percent, and the currency lost 12.8
percent against the dollar in 2013.

Economies with robust current-account surpluses such as
Taiwan and South Korea have fared much better. And the South
Korean won is one of the few emerging-market currencies to rise
against the dollar. Also, inflation has been low.

Investors have flocked to South Korean stocks recently.
From July through late December, $14.4 billion flowed in,
reversing the $8.2 billion that left in the first six months of
2013. South Korean equities aren’t cheap, trading at 16.8 times
earnings over the last 12 months, but foreigners want to invest
in the country’s companies, especially in the technology, retail
and automobile sectors.

As noted, the South Korean economy fits between the rich
countries of Europe, the U.S. and Japan and the developing
countries. Still, because of its heavy dependence on exports (56
percent of GDP), it resembles emerging markets in a world where
export-led growth is no longer a winning game. The economy’s
dominance by the chaebol conglomerates (82 percent of GDP) is
also more typical of developing than mature economies.

At the same time, the low inflation rate is more
characteristic of developed nations. The government’s attempt
after the 1997-1998 Asian crisis to spur consumer spending to
reduce foreign exposure caused household debt to explode, and it
is now a troubling 135 percent of disposable personal income.

The low household saving rate, low fertility rate and aging
population limit long-term growth unless productivity growth
leaps or a reunion with North Korea unleashes a new wave of
development.

Chronic government surpluses and low debt are advantages
for South Korea, however. So, too, are huge foreign exchange
reserves built up from years of current-account surpluses. It
ranks 34th out of 177 countries for economic freedom. Other
pluses include the highly educated workforce, a robust work
ethic and solid banks.

That is why South Korea should be near the top of the list
for investors interested in developing/semi-developed country
markets.

(Gary Shilling is a Bloomberg View columnist and president
of A. Gary Shilling & Co. He is the author of “The Age of
Deleveraging: Investment Strategies for a Decade of Slow Growth
and Deflation.” This is the third in a three-part series. Read
Part 1 and Part 2.)